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One of the most popular trends emerging in portfolios over the past several years has also been one of the oldest--and most effective--tricks in the investing playbook: dividend-paying stocks. Whether as a result of the prolonged period of low interest rates or general uncertainty over the macroeconomic outlook, investors of all shapes and sizes have been flocking to dividend paying stocks as a way to boost current returns and lower overall volatility.

Generally, I'm a huge fan of ETFs for just about every investment objective. But I'm also realistic about the limitations of rules-based strategies, which can certainly exist when attempting to implement a dividend-centric strategy. Many dividend ETFs (there are more than 50) focus solely on stocks with a lengthy history of increasing their dividend, a tact that often results in a portfolio with a yield comparable to the broader market. Conversely, rules-based strategies that focus exclusively on yield have a tendency to include more speculative, volatile stocks that may be exhibiting high yields as a result of beaten down stock prices and distressed operations.

Dividend investing is extremely popular--with good reason. But finding the right strategy isn't as simple as the push of a button (Photo credit: seanmcmenemy)

Coming up with an effective dividend-focused strategy involves quite a bit of flexibility, and a little bit of creativity. There are a lot of financial products out there that offer exposure to dividend-paying stocks, but the one I want to highlight today you've probably never heard of: the Inflation Managed Dividend Fund (GAINX) from Guinness Atkinson.

As the name suggests, the fund takes into account a factor that's often overlooked: the ravages of inflation on a long-term portfolios. GAINX seeks to deliver current returns and dividend growth that exceeds the rate of inflation--a relatively common desire among investors--but takes a unique path to get there.

Importance Of Dividends

It's worth discussing the rationale behind focusing on a portfolio of dividend-paying stocks in the first place. There's ample evidence to suggest that stocks that are able to steadily increase their dividend will deliver superior returns to the broad market; between 1972 and 2010, the companies of the S&P 500 that grew or initiated dividends outperformed those that cut or eliminated dividends by a wide margin (hardly a surprising fact). Moreover, they beat the universe of all dividend payers quite handily, and distanced themselves from the companies that kept distributions constant:

There's also a compelling case to be made for dividends as a source of protection from inflation that can erode purchasing power significantly over the long term. Dividend growth and inflation show strong correlations over extended periods of time, meaning that dividend-paying stocks can be part of the equation for those concerned about the adverse impact of rising prices.

"10 Over 10"

When building a portfolio of dividend payers for the long haul, there's a tendency to focus on historical dividend data. That seems obvious, but it might not be the most effective starting point. Knowing that companies that are able to steadily increase dividends have historically outperformed their peers, it makes sense to focus on metrics that indicate a company will likely be able to consistently generate cash flows going forward.

GAINX starts by identifying companies that meet the "10 Over 10" criteria--generating Cash Flow Return On Investment of 10% or more over the previous 10 years. That whittles down the global stock universe to the select few that have proven an ability to generate returns in excess of the real cost of capital over at least a full business cycle--only about 3% of the total stock market meets this criteria.

From there, the field is narrowed down to those with debt-to-equity ratios of less than 1.0, eliminating those stocks whose debt burdens may prevent them from growing distributions substantially going forward. Those remaining are ranked on fundamental metrics such as value, analyst sentiment, and price momentum.

Screening companies using 10-year CFROI won't necessarily leave you with the highest yielding stocks or those with the longest track records. What it will (generally) deliver, however, is a universe of companies that can reasonably be expected to continue generating cash flows and increasing the amount of cash they return to their shareholders. Based on the data presented in the chart above, that's a rather desirable segment of the broader global equity markets.

Once that universe is defined, the rules-based framework passes the baton to active managers who make the ultimate buying decisions to construct a portfolio consist of about 35 individual names. Note that dividend yield never explicitly comes into the equation--yet that process yields a portfolio of stocks that generally yield more than 2%, and that in aggregate have a yield that exceeds broad-based stock indexes.

It's an unconventional way to come up with a portfolio of dividend-paying stocks, but it's rather effective. At the end of July GAINX had a SEC yield of about 3.6% according to its most recent fact sheet generated from a portfolio that consists of some of the most consistent cash generators in the world.

Under The Hood

Top Sectors & Countries

Sector

Country

Pharmaceuticals

15.0%

U.S.

47.4%

Food

8.8%

Great Britain

28.7%

Soap & Cleaning

6.1%

France

8.9%

Non-Alcoholic Bev.

5.9%

Hong Kong

3.0%

Telecom

5.9%

Australia

3.0%

The GAINX portfolio includes some of the "usual suspects" that often make their way into dividend-focused strategies; the fund includes names such as Proctor & Gamble, Pfizer, Shell, Johnson & Johnson, Aflac, and Total SA. But it's also full of names that might not be as familiar to investors, yet that meet the criteria set forth for inclusion: Illinois Tool Works, Halma PLC, and ICAP PLC are some of the stocks that probably aren't on nearly as many radar screens.